Tokyo’s Test: Policy vs. Demographics

Elderly people work out in the grounds of a temple in Tokyo in September to celebrate Japan’s Respect for the Aged Day. The estimated number of people aged 80 or older in Japan topped 10 million for the first time, the government said.

YOSHIKAZU TSUNO/AFP/GETTY IMAGES

Japan is running an economic experiment with significant implications for the rest of the world, testing whether strong policy can offset weak demographics.

For nearly a quarter century, Japan has been the cautionary tale for advanced economies, enduring persistent stagnation, a debilitating deflation, and a rapidly aging, shrinking population. While Japan is the world’s first “superaged society”—defined as a country where at least 20% of the population is elderly—more than 30 countries will hit that benchmark by 2050. So Japan’s ability to cope is being closely watched elsewhere.

For many years, Japan’s response was denial. Even as the country’s fertility rate started plunging from the early 1970s, the nation’s demographers consistently issued reassuring forecasts until the early 2000s that the number would rebound.

Then came passive acceptance. Key policy makers argued Japan’s demography determined its economic destiny, that a contracting population inevitably dictated the country’s deflationary decline: the vicious cycle of falling demand, falling production and investment, and falling prices, profits and wages.

A leading spokesman for that school was Masaaki Shirakawa, the governor of the Bank of Japan from 2008 through 2013, who defiantly fended off politicians and executives demanding aggressive monetary stimulus, arguing that it would be futile in the face of Japan’s population problems.

In May 2012, Mr. Shirakawa delivered a widely cited speech titled “Demographic Changes and Macroeconomic Performance: Japanese Experiences.” In it, he cited global evidence that “the population growth rate and inflation correlate positively,” a finding he called “a sharp contrast with the recently waning correlation between money growth and inflation.” In other words, a country like Japan with a shrinking population was inevitably condemned to slow growth and deflation, and central banks were impotent to fight it.

Whatever the economic merits of Mr. Shirakawa’s argument, the seeming defeatism became politically untenable. Shinzo Abe’s party won a landslide electoral victory in December 2012 on a Shirakawa-bashing platform seeking a turn in monetary policy. Prime Minister Abe’s choice for Bank of Japan governor, Haruhiko Kuroda, promised a radical increase in the amount of money pumped into the economy, and an end to deflationary stagnation, even while the country’s population continued to shrink.

Just over two and a half years into his term, Mr. Kuroda has delivered well on the first pledge, with two rounds of “quantitative and qualitative easing” that more than doubled the BOJ’s asset-purchase plan used to create fresh liquidity. The jury is still out on his second pledge, to end deflation and revive Japan’s economy.

The bad news: Japan’s gross domestic product contracted for the two consecutive quarters ended Sept. 30, pushing the country into recession for the second time during Mr. Kuroda’s brief term. Some of that results from cyclical problems and policy missteps outside Mr. Kuroda’s control: the slowdown in China, an ill-timed sales tax hike. But some stems from the fact that economy’s capacity to expand is constrained when the workforce is shrinking, making recessions much more common.

The battle to break deflation has also struggled, due both to falling oil prices and the slow growth that has damped price pressures. After some early success in pushing the most closely watched inflation gauge above 1%, deflation returned over the summer, and the Japanese government reported Friday that the consumer-price index was negative in October for the third month in a row.

But the BOJ released Friday its own preferred measure—stripping out prices for food, energy and other items that the central bank considers distorting of underlying trends—that showed inflation rising in October at a more robust positive 1.2% annual rate. The aggressive monetary policy has also helped create the tightest job market in a generation, with a separate Friday report showing the unemployment rate dropping to an eye-popping 3.1%. That, in turn, has helped expand the labor market by prompting employers to find more ways to use older workers conventionally considered past retirement age. The jump in employment in Japan by those 65 years and older has kept the size of its labor force fairly stable, even as the classically defined “working-age population” has contracted. Whether Japan’s newly aggressive monetary policy can really overcome the demographic drag hinges on whether Japanese companies can be persuaded to invest more at home. An economy’s ability to grow is rooted in the expansion of its labor force, combined with the ability to boost its labor productivity, or output per worker. Productivity can be lifted by investment in labor-enhancing equipment.

It’s not a stretch to imagine that higher capital spending could more than make up for the effects of an aging, shrinking population. In a Nov. 13 report, Goldman Sachs Japan Co. Ltd. economists calculated that, while labor input has been a steadily increasing drag on the country’s production capacity since 1991, capital stock and total factor productivity offset that through about 2007. “Annualized growth between 1.5% and 2.5% in capital stock is needed to maintain production capacity in the future,” they estimate—an ambitious, but not outrageous, pace, falling somewhere below the rate of the high-spending 1980s and 1990s, and above the low-spending years of the early 21st century.

What would it take to push capex that high? Mr. Kuroda has succeeded in creating conducive conditions, notably helping Japan’s big multinationals generate record high profits, thanks to the yen’s dramatic depreciation, which has pumped up the value of overseas earnings when converted back home into the local currency. And BOJ surveys earlier this year suggested large manufacturers planning a 20% increase in capex. That hasn’t materialized. “GDP statistics show business investment contracting by 1.2% in real terms in [the second quarter], and by 1.3% [quarter over quarter in the third quarter],” BNP Paribas said in a note Friday.

In order to lift capex to the necessary levels to return Japan to the path of prosperity, “we see a need to convince corporate executives that the Japanese economy will return to sustainable growth and to reduce uncertainty,” the Goldman report said. In other words, Japan’s experiment is stymied by a kind of Catch-22. Companies may well have the potential to invest sufficient amounts to minimize the effects of the population decline. But they won’t spend the required money if they continue to believe that unfavorable demographics cloud the country’s future.